The Role of Real Estate in a Portfolio

Real estate returns show a low correlation with returns on equities or bonds

Summary

Real estate has long been seen as an attractive hunting ground for investment returns by institutional and individual investors alike. When introduced into a multi-asset portfolio, real estate offers key diversification and inflation hedging benefits, potentially enhancing the portfolio’s risk-adjusted returns.

With the right asset mix, a skillfully constructed real estate portfolio can also offer an income stream that is relatively stable through market ups and downs.

While the evidence is strongest for private or unlisted real estate, there are practical benefits to adding both private and listed real estate investments to a portfolio.

Why invest in real estate at all?

1. Diversification

Multiple studies have shown that real estate returns display a low correlation with returns on listed equities or bonds (Exhibit 1). This means that adding real estate to a portfolio comprising mainly equities and bonds can help reduce the total portfolio risk, potentially enhancing its risk adjusted returns.

Source: Bloomberg, MSCI

Real estate assets are typically priced on a local basis and the performance of individual properties is heavily influenced by local supply and demand dynamics and regulations. Even within a single country, local drivers of real estate returns are likely to vary across different locations and property types such as office, retail, industrial and residential. This means that adding a large number of properties across multiple locations and property types to a portfolio of equities and bonds can offer a double or triple diversification benefit.

The evidence is strongest for private or unlisted real estate, although several studies have concluded that it is beneficial to add both private and listed real estate investments to a portfolio, according to a 2015 review of academic studies since the early 1980s by Norway’s sovereign wealth fund.

2. Inflation hedging

Real estate returns tend to be more closely correlated with inflation over time compared with equities or bonds, especially when inflation is accelerating. A key reason is that real estate leases typically adjust to reflect changes in inflation, especially for commercial property such as office space, while property prices tend to rise with the cost of construction, which increases with inflation. This means that adding real estate to a mixed-asset portfolio can provide a valuable inflation hedge for investors seeking to preserve their purchasing power, especially when inflation is accelerating.

Sources: Singapore Urban Redevelopment Authority, Bloomberg

3. Stable income with the right asset mix

Income from rentals typically contributes a large proportion of global real estate returns (Exhibit 3). A skillfully constructed real estate portfolio comprising multiple high-quality properties with long term leases that expire at different times can offer a rental income stream that is relatively stable even through short term market ups and downs.

Source: MSCI IPD Global Annual Property Index

Sophisticated investors have long sought to reap these benefits

As at July 2018, there were 499 institutional investors worldwide allocating US$1 billion or more to real estate, led by the Abu Dhabi Investment Authority with US$62 billion, according to alternative-asset data provider Preqin.

Other sophisticated asset managers also explicitly allocate part of their portfolios to real estate to harvest the associated benefits.

“We invest in real estate to improve the fund’s risk-return profile and to achieve a more diversified portfolio,” Norway’s Government Pension Fund Global states in a March 2018 report. “We expect real estate investments to have a different return profile to equities and bonds in both the short and the longer term,” the fund states in its 2017 annual report.

Conclusion

Adding real estate to a mixed-asset portfolio offers key diversification and inflation hedging benefits, potentially enhancing the portfolio’s risk-adjusted returns. With the right asset mix, a skillfully constructed real estate portfolio can also offer an income stream that is relatively stable through market ups and downs. The evidence is strongest for private or unlisted real estate, although there are practical benefits to adding both private and listed real estate investments to a portfolio. Investing in real estate entails significant risks, which can be reduced by spreading the real estate portfolio widely across various locations and property types.